Business Context and Reporting Period
Data Storage Corporation provides cloud-based storage, disaster recovery, business continuity, infrastructure-as-a-service, email archiving and compliance solutions to customers in multiple industries. This unaudited Form 10-Q covers the three and nine months ended September 30, 2016, with comparisons to the corresponding 2015 periods. The company had 36,588,240 common shares outstanding at September 30, 2016.
Financial Metrics
| Metric | Three Months Ended September 30, 2016 | Three Months Ended September 30, 2015 | Nine Months Ended September 30, 2016 | Nine Months Ended September 30, 2015 |
|---|---|---|---|---|
| Sales | $922,919 | $930,686 | $2,912,152 | $2,988,503 |
| Gross profit | $300,083 | $317,770 | $1,051,004 | $1,123,123 |
| Gross margin | 32.5% | 34.1% | 36.1% | 37.6% |
| Operating expenses | $413,211 | $415,984 | $1,354,785 | $1,446,856 |
| Loss from operations | $(113,128) | $(98,214) | $(303,781) | $(323,733) |
| Net loss | $(185,721) | $(138,481) | $(509,311) | $(515,587) |
| Net loss attributable to common stockholders | $(211,899) | $(162,775) | $(587,861) | $(586,693) |
| Loss per share | $(0.01) | $(0.00) | $(0.01) | $(0.02) |
Operating cash flow for the first nine months was $208,577, compared with $22,957 in the prior-year period. Financing activities used $170,151, primarily for capital lease repayments. Cash increased to $105,471 from $67,045 at December 31, 2015. The company reported a working-capital deficiency of $3,672,690.
At September 30, 2016, total assets were $3,223,869, total liabilities were $5,525,956, and stockholders’ deficit was $2,302,087. Current liabilities totaled $4,157,205, compared with current assets of $484,512.
Debt and obligations included a $99,292 revolving credit facility, a $350,000 bank note, $2,101,363 of convertible debt owed to related parties, and $408,412 of capital lease obligations, of which $252,841 was current. The revolving facility bears interest at prime plus 0.5% and is secured by company assets and personally guaranteed by the principal shareholder.
Material Changes Versus the Prior Comparable Period
- Third-quarter sales declined 1.0%, and nine-month sales declined 2.6%, primarily because of lower subscription revenue.
- Third-quarter gross margin fell to 32.5% from 34.1%; nine-month gross margin fell to 36.1% from 37.6%.
- Third-quarter net loss increased 34% to $185,721, despite slightly lower operating expenses, mainly because of weaker gross profit and a swing in the equity-method investment from a $31,625 gain to a $2,362 loss.
- Nine-month net loss improved slightly by $6,276, or 1.2%, primarily because operating expenses declined 6.4% and interest expense declined $14,362.
- Nine-month selling, general and administrative expense declined, including a $167,134 reduction in salaries, while marketing expense increased by $79,540 to $106,865.
- Accounts payable and accrued expenses increased to $1,619,019 from $1,051,349, while total liabilities increased by $382,499 from year-end 2015.
Outlook, Risks, Contingencies and Unusual Items
- Management states that continued operations depend on sales growth, expense reductions, additional financing and achieving profitable operations. The CEO and largest shareholder has historically funded the company and stated an intention to continue doing so as needed.
- The $350,000 bank note was in default as of September 30, 2016. The company was negotiating with the bank for a self-amortizing loan.
- Several related-party convertible notes had passed their stated maturity dates or were in default. On October 10, 2016, the board approved conversion of specified related-party debt into equity, with interest payable through October 25, 2016.
- On October 25, 2016, after quarter-end, the company acquired certain assets and service agreements from ABC Services entities for an aggregate 64,669,936 shares. The share amount could be reduced if audited 2015 revenue for either seller was below $2 million.
- Also on October 25, 2016, the company converted $2,678,124.28 of affiliate debt into 26,781,242 common shares at $0.10 per share, subject to a potential upward conversion-price adjustment capped at $0.20.
- Potential dilution was significant: 7,045,463 options and 133,334 warrants were outstanding at September 30, 2016, in addition to the post-quarter-end share issuances.
- One customer represented 19% of nine-month sales, creating customer-concentration risk.
- Management concluded that disclosure controls and internal control over financial reporting were not effective because of insufficient accounting expertise and inadequate segregation of duties. Management intended to add finance personnel.
- The filing reports no material litigation and no defaults upon senior securities during the reporting period, but separately identifies the bank note and certain related-party notes as being in default or past maturity.
- The company was evaluating several new accounting standards, including revenue recognition, leases and cash-flow classification standards; no near-term material impact was expected based on the filing.
Most Important Facts for Investors to Verify
- Whether the company can address its $3.67 million working-capital deficiency and continue obtaining financing or shareholder support.
- The status, terms and enforceability of the bank-note default and negotiations for revised repayment terms.
- The final amount and accounting treatment of the October 2016 ABC asset acquisition, including any revenue-based share reduction.
- The effect of the October 2016 debt conversions and ABC acquisition on ownership, dilution, control and future share count.
- Whether management remediates the identified material weaknesses in internal controls.
- The sustainability of positive operating cash flow, given continuing net losses, declining revenue and large current obligations.
- The effect of the 19% customer concentration and any changes in subscription revenue trends.
- Potential impairment of goodwill, intangible assets and other long-lived assets, which totaled significant portions of the company’s asset base and depend on management estimates.